Economics and...

Porn and Transportation are Substitutes

2008-07-06T00:55:00.006-04:00

OK, I couldn't leave this one alone. Greg Mankiw points to some research showing that "many websites focused on adult or erotic material have experienced an upswing in sales in the recent weeks" since the stimulus checks were mailed out. I can buy the theory that many of their marginal customers are liquidity constrained, which I'm guessing is the way Greg sees it, but there's another issue here that hasn't been addressed. The stimulus checks are only one of a number of things that have happened over the past few months. You might also have noticed, for example, a dramatic increase in the price of gasoline, coming at a time when people were already adjusting to dramatic increases over the past 4 years. I think that particular change is an important part of the picture.

"Adult or erotic material" is a form of entertainment, or, if you will, recreation. But unlike various other forms of entertainment and recreation, it can be consumed at home. And I suspect that a lot of people think it's more fun than most other forms of entertainment and recreation that can be consumed at home. You can go out to a bar or a club or a ball game or a movie or a show or the beach or, well, a brothel, if you're in Nevada, or you can stay home and consume forms of entertainment that can be consumed at home. I can remember seeing a story recently (I don't remember where) about how brothels in Nevada are being hit hard by the economic slowdown. If you stay home, you don't have to use up gasoline, so the relative cost of at-home entertainment goes down when the price of gasoline goes up. Adult Web sites are probably not a Giffen good, so, if we could hold other income constant, we should expect that the demand for adult Web sites should go up when the price of gasoline goes up.

Granted, other income isn't constant. The rising price of gasoline affects a lot of other areas besides entertainment and recreation, so it represents a general decline in real income. And the economy is weak. So maybe the stimulus checks compensate for these declines in income. If the effect of the stimulus checks is to bring income up to the level that it was before the increase in gasoline prices, we should expect an increase in demand for adult Web sites. So the stimulus checks matter, but it isn't just the stimulus checks.

I should give credit where credit is due. The basic substance of this idea about gas prices and porn comes from this YouTube video:

Not coincidentally, the woman in the video (Isobel Wren, whom you may remember from an earlier post on this blog) has her own Web site "focused on adult or erotic material." And in the interest of smoothing the transition to a less energy-intensive economy, or maybe just to be naughty, I'll give you the link again. (Note that it is an adult Web site, so don't click the link unless you're over 18 and your boss isn't watching.)

UPDATE: I just noticed that this video is the same one that I linked to in the earlier post. Oh, well, now you get to watch it in embedded form.

Should we develop alternative fuels?

2008-06-16T19:40:00.003-04:00

Until someone convinces me otherwise, I'm going to go with "no" -- at least if by "fuels" you mean carbon compounds that are used to release energy through combustion. Combustion of carbon compounds produces carbon dioxide, which aggravates global warming. If we're running out of oil, let's just run out, start driving less, flying less, doing less of things that produce greenhouse gases, and doing the remainder more efficiently. Or else let's find replacements that don't involve "fuels" in the sense I described: try electric cars that run on power from wind, solar power, hydroelectric power, nuclear power, etc..

From an environmental point of view, running out of oil is a good thing, an opportunity to slow down climate change, and are we now to try replacing that oil with other combustibles? When opportunity knocks, close the curtain and pretend you're not home?

If the government is going to subsidize anything, let it subsidize alternative sources and uses of electric power, or solar heating, or something like that. Why subsidize products that are going to aggravate our environmental problems?

Pigou and the Anthropophagi

2008-06-12T19:26:00.003-04:00

Why does the salmon here cost more than the chicken? There ought to be a tax on chicken.

Why?

On chicken and meat and eggs and dairy products.

Why?

Because farm animals are bad for the environment.

How?

They contribute to global warming.

How?

They produce methane, which gets in the atmosphere and adds to the greenhouse effect.

People produce methane, too, you know.

That's why I think there should be a tax on people also. Cannibals need more vegetables in their diet anyhow.

Definition

2008-05-14T15:48:00.006-04:00

Sex worker:

(1) a prostitute

(2) anyone in a sex-related occupation, including a psychiatrist with a specialization in sexual disorders or a cashier in a convenience store that rents adult videos

(3) someone in an occupational category broader than (1) and narrower than (2), the precise specification of which is known only to the person using the term

Examples of (3):

(a) Anyone who acts in an adult video, is a sex worker, but someone who works in distribution of adult videos is not.

(b) Anyone who has, on camera, actual penetrative intercourse involving an actual male member, is a sex worker, but someone who engages, on camera, in Lesbian sex acts, including those that involve penetration, is not.

(c) Anyone who interacts sexually directly with a client, whether or not that interaction includes an actual sex act, and whether the interaction is in person or over some kind of telecommunication network, is a sex worker, but someone who performs sex acts on camera, for distribution as entertainment, is not.

Supply Response and Self-Unfulfilling Recession Prophecies

2008-05-01T11:03:00.004-04:00

In a post last year, I argued that one reason economists have not successfully forecast recessions is that recession forecasts, or near-recession forecasts, prompt policymakers (usually the Fed) to act so as to prevent a recession. Only when the recession is unexpected (i.e. not forecast) will policymakers fail to act.

Spencer, an occasional blogger at Angry Bear and a frequent commenter on many different economics-oriented blogs, suggested (in a comment somewhere; I don’t remember where or when) another mechanism that operates through inventories. When manufacturers expect a recession, they reduce their inventories in anticipation, thus inducing themselves to increase production later, thereby preventing the recession they had expected. So again, a recession only occurs when it is unexpected, when manufacturers are caught with excess inventories because they hadn’t anticipated weaker demand.

Here I’m going to suggest a third mechanism whereby forecast recessions may tend to prevent themselves. The idea comes from this YouTube video, in which a model* discusses, among other things, her concerns about the weakening economy. Her response to those concerns: “I’m trying to book up as much work as I possibly can and get some savings cushions built up.”

This phenomenon may be specific to the modeling industry. Indeed, it may be specific to the particular model in the video. But I see no reason not to expect it to be more general. Intertemporally optimizing businesses, and self-employed individuals, in many service-producing industries (and for that matter, workers in all industries) may have a general incentive to shift their supply curves outward in response to the expectation of a future inward shift in demand curves. Thus the expectation of a recession would result in an immediate increase in economic activity.

I’m not sure what the full implications of this hypothesis are for the business cycle. It’s kind of the opposite of Spencer’s idea, in that here the expectation of a recession causes agents to produce more in the immediate time frame rather than less. I suspect, though, that manufacturers are better at planning at quarterly or longer horizons than are service-producing industries (and certainly individuals), so I suspect that the paring down of inventories happens well in advance of the expected recession, whereas the supply curve shift happens at about the time the recession is supposed to start. (The video example, one may note, took place in mid-April of this year, by which time many people believed that the US was already in a recession.) If the supply response is tardy enough, it could surely have the effect of preventing (or at least delaying) the recession to whose forecast it is responding.

*UPDATE: It occurs to me that I should identify the model, instead of just exploiting her as an example of a concept. Her name is Isobel Wren. She has a nice portfolio on One Model Place, and she also has her own Web site (Adults only. Not work safe.). She calls herself "the thinking man's nympho" and prides herself on being a nerd when she's not in front of the camera.

Bear Sterns

2008-03-30T11:04:00.007-04:00

I started this post last Monday and then got distracted. Looking at it now, I think the fragment is worth preserving.

I’ve spent the past week being pissed off at all the people who were pissed off about the so-called “bailout” of Bear Stearns. In the light of this morning’s [Monday the 24th] news, I’m starting to half agree with them.

Earlier, I was going to write a post about what a lucky accident it was that the current Fed Chairman is also one of the world’s foremost experts on the problems of the early 1930’s. Now I’m beginning to wonder if it would have been better to have someone with a less well-matched academic background and more poker skills.

In retrospect, it appears that the $2/share price in the original version of the Bear deal was not a real price, just a piece of propaganda, intended to give the impression that it wasn't a bailout. But it's now clear that, whether or not one calls it a bailout, Bernanke offered a lot more in loan guarantees than was really required to get J.P. Morgan to do the deal. (The $1 billion deductible on the new version of the deal is not very convincing as a concession by Morgan, and in any case, it only makes it more obvious that the Fed's original offer was much higher than it needed to be, if Morgan is willing to take a hit both on the special financing and on the purchase price.)

I don't think that's exactly a moral hazard problem, but it's the same general idea. The next time the Fed wants somebody's help to keep the financial system afloat, that somebody will know to charge dearly for that help.

UPDATE: And another thing. What the hell were Ben's priorities? If he wanted to reassure the financial markets, he shouldn't have pushed for a price that made Bear Stearns appear to be in much worse shape than it actually was. (Did that just not occur to him? Did it not occur to Tim Geithner? Did it not occur to anybody at the Fed?) If he wanted to make the Fed look tough, he shouldn't have offered way better financing terms than were really needed to get the deal done. (As noted above, both the price and the financing terms got worse for Morgan subsequently, and they were still willing to play.) Did it not occur to him that being tough with winners was important for the Fed's reputation too, as well as being tough with losers? This was a major screw-up.

Where is “Sex” in the NAICS?

2008-03-22T23:18:00.006-04:00

This business with Eliot Spitzer is bringing up issues in labor economics for me. In particular, how should we refer to Ms. Dupré’s occupation? Some people insist that she was a “sex worker.”

I have a number of problems with this terminology. For one thing, is there any other occupation where the title includes “worker” and the hourly billing rate can be in the quadruple digits? I mean, there are a few cinematic production workers who make that kind of pay – but they’re known invariably by other titles (actors, directors, etc.) – and a few sports workers – but they’re known as athletes – and quite a few finance workers – known as investment bankers, fund managers, and such – and quite a few…I guess I’d have to call them generic workers, since they can be in any industry…but they’re known as corporate executives – and a few legal service workers known as attorneys, and a few professional service workers known as consultants, and maybe a few health care workers known as doctors and surgeons, and so on.

Which brings me to my second, related point, which is that we don’t normally identify an occupation by the industry to which it belongs. The exceptions are sort of residual categories: we do call some people “health care workers” if we can’t think of anything better to call them, but most people in health care occupations (nurses, for example) would probably find it insulting to have their occupation identified as “health care worker.”

According to Wikipedia, a sex worker is someone (anyone, apparently) who works in the “sex industry.” I have a feeling that many people who work in the “sex industry” would be insulted to be called “sex workers” (rather like nurses, if you call them “health care workers”). I mean, really, doesn’t everyone know that the phrase “sex worker” is a euphemism for “prostitute”? (I know, technically, that’s not the case, but in real life, other “sex workers” seem to use the phrase for themselves only when they’re trying to make a show of their solidarity with prostitutes.)

But here’s the real problem: What the hell is the “sex industry”? And more to the point, what kind of industry is it?

An information industry? (The adult video industry, as best I can tell, is part of NAICS 512110, “Video production,” an information industry.)
A personal service industry? (Officially, Miss Dupré was probably working in NAICS 812990, the “Social escort services” industry, a personal service industry. As to what she was actually doing, it seems to me that prostitution is clearly a service, and it’s about as personal as services get.)
A food service industry? (I know that doesn’t make much sense, but where do strip clubs fit in the NAICS? As best I can tell, they are part of NAICS 722410, “Night clubs, alcoholic beverage,” a food service industry.)
An entertainment industry? (It’s really tough to find a NAICS code that would actually apply here, but aren’t strippers entertainers? Of course strippers also give lap dances, which are really more of a personal service than a form of entertainment. In fact, in that respect I have to question whether strippers are really more like prostitutes than entertainers.)
An amusement and recreation industry? (That’s pretty much just a wild guess. But where the hell do brothels fall in the NAICS? There are legal brothels in Nevada, so I assume they must have a NAICS code.)

As far as I can tell, the whole concept of a “sex industry” makes a mockery of the way we normally classify industries. I don’t have a problem with changing the occupational title of prostitutes to something that has less of a stigmatizing history. But “sex worker” just doesn’t do it for me. I’m going to try “personal sexual service provider” (PSSP for short) and see if it catches on. Otherwise I’ll just call them hookers – a term which doesn’t seem to offend people even though its etymology is rather scurrilous.

What's going on?

2008-03-21T17:31:00.003-04:00

In Paul Krugman’s latest column (hat tip: Mark Thoma), he compares the current financial crisis to the bank runs of 1930 and 1931:

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

That sounds like a pretty good description of what’s going on, but there’s something missing. Thinking about this as a regular person rather than an economist, I have to ask, “Who are these ‘people’ that are pulling their money out of the shadow banking system and putting it into treasury bills?” Because it sure isn’t me. I have my cash in a prime money market fund; I deliberately passed up the “treasury-only” option, and I see no reason to change my mind now. My fund hasn’t broken the buck. In fact, I haven’t heard of any money market fund that has broken the buck recently. (Possibly something escaped my attention, with all the news that’s come out lately, but even if there have been one or two cases, there haven’t been many, and they haven’t been big ones.)

I don’t know exactly what my fund manager is doing; I imagine they’ve probably increased the proportion of treasuries in their portfolio, and I guess, technically, it was “people” that made that decision, but it wasn’t any people that I know personally. If anything, I’d like my fund to skate closer to the edge. It would not drive me into bankruptcy if the share price went from $1.00 to $0.99. In fact, I probably wouldn’t even notice, except for the fact that I’d read about it in the newspaper, and the fund would probably send me all kinds of stuff in the mail about how something went terribly wrong and the employee has been fired and this will never ever happen again in a million years and they’re completely changing all their control procedures and they’re changing their name just to show that they aren’t really the ones who lost that one cent.

So I guess the point is, it’s not really “people,” in the sense of retail investors, who have lost confidence; it’s institutions. Maybe that’s why so many “people” have a hard time seeing what the big deal is and why the Fed needs to help “bail out” Bear Stearns. As for me, when I see the TED spread approaching 200 basis points and the treasury bill rate approaching zero, I know that something is very wrong and that the Fed has good reason to be taking drastic measures, but I’m still a little confused as to why all this is happening. I understand that the consequences of the failure of a major investment bank under these conditions would be disastrous, but I still have trouble seeing why J.P. Morgan needed $30 billion in non-recourse financing to convince it to buy Bear Stearns for a tiny fraction of what the market seemed to think it was worth.

Capital Flight is Good

2008-03-17T19:15:00.003-04:00

Some people (Yves Smith and Tim Duy, to name two, but I’m sure there are many others that I haven’t gotten around to reading yet) are worried that concern about capital flight is going to have to be a constraint on the Fed’s ability to deal with this crisis. I disagree. I don’t think the Fed will or should be concerned about capital flight. In fact, I think capital flight is part of the solution, not part of the problem.

In general, capital flight is a problem if you care about quantities that are not denominated in your own currency. If all the quantities you care about are (or can be) denominated in your own currency, then you can just print as much currency as you need to replace the foreign capital. There are basically 4 situations where capital flight is a problem, which I will call the 4 Fs:

Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.
Fixed exchange rate. If you need to defend an exchange rate, the government will effectively have to supply exiting capital out of limited official reserves. This was a large part of the problem in the early 30s. But today the US does not have an obligation to defend its currency, nor does it have (about which see the rest of this post) and interest in maintaining its currency’s value.
Foreign currency-denominated debts. If you have to pay back foreign currency, you’ll be in trouble if capital flight weakens your own currency and thereby makes foreign currency harder for you to get. This has been a problem in various places, particularly Latin America, in the past, but it’s not an issue for the US today: almost all our debts are denominated in dollars.
(in)Flation. If your country is experiencing, or on the verge of experiencing, an unwelcome inflation, capital flight will exacerbate the problem by weakening your currency and thereby raising import prices. As of 8:29 AM on Friday, I still thought this was an issue for the US today. I no longer do.

For the US today, the real problem would be if foreigners insisted on continuing to purchase US assets. That would support the dollar, making it that much harder to sell US goods and services and contributing to the weakening of the economy, thereby exacerbating the positive feedback between a weak economy and a weak financial system.

As long as inflation was a major issue, there were limits to what the Fed could do to stabilize the domestic financial system. It could only take on mortgage securities, for example, up to the point where it used up all its assets. In that situation, an absence of foreign demand for US securities might be a big problem.

If, as now appears to be the case, the risk of deflation is a bigger issue than the risk of inflation, then there is no limit to what the Fed can do. If it runs out of assets, it just prints more money to buy assets with. If foreigners refuse to buy US assets, the Fed prints money for Americans to buy them. If Americans refuse to buy risky assets, then the Fed can trade its own assets for risky assets through programs like the TSLF. Or lend money directly against risky assets. If foreigners withdraw capital, the Fed can replace it with newly created money. (Actually, it won’t need to, because when the proceeds from the withdrawn capital are converted out of dollars, the counterparty to that conversion will have dollars to invest.)

If the dollar weakens, so much the better. $2/Euro. $3/Euro. In the words of Chico Marx, “I got plenty higher numbers.” It might be a problem for Europe, but not for the US (and for Europe it would be a self-inflicted wound, since there is plenty of room to expand the supply of euros if there were a will to do so).

There is no limit to the potential magnitude of the Fed’s actions, but there could conceivably be limits to the effectiveness of those actions even as the magnitude becomes infinitely large. That situation is exactly one where capital flight would be a good thing. If the Fed can’t manage to stimulate the economy sufficiently by printing money, the stimulus has to come from somewhere else. Increased demand for US exports, due to a weak dollar, due to capital flight, is one of the chief candidates.

Moral Hazard

2008-03-16T23:54:00.001-04:00

[Hypothetical future investor]: I own a major stake in an investment bank, and I’m getting concerned about their risk management. Should I bring this up at the shareholders’ meeting?

[Hypothetical friend]: I don’t see why. What’s the worst that can happen? The bank will go sour, the Fed will arrange a bailout, and you’ll only lose 95 percent of the money you invested, 96 tops. What’s the big deal?

[Hypothetical future investor]: You’re right. Isn’t the [Hypothetical future Fed chairman] put great?

TSLF: Is the government taking a risk?

2008-03-16T18:36:00.002-04:00

In one of the latest blogospheric analyses of the Fed’s plans to accept private-label mortgage backed securities as collateral, James Hamilton concludes that the government is taking on a definite risk (specifically, although the Fed is the agent, it is really the Treasury’s risk, since the Fed’s profits are received by the Treasury) but that the risk is not a very large one. I wonder, though, if it’s appropriate to view the risk characteristics of the specific transactions in isolation without considering how they influence the Treasury’s other risks.

Modern portfolio theory teaches us that an asset that looks risky in isolation can actually decrease the risk of a portfolio. For example, if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky. In that context it is the correlation (or rather, lack thereof) between asset returns that is the issue, but in the case of the government itself, a more important issue is how transactions in one set of assets affect the value of other assets and liabilities.

In particular, the government’s most important asset, in real economic terms, is the expectation of tax revenues. Tax revenues depend mostly on incomes. In particular, revenues depend not on potential incomes but on actual incomes, so any expected gap between the two reduces the value of the government’s most important asset. The government’s most important liabilities are the securities it issues, most of which are denominated in nominal dollars and most of which do not contain a call provision. A worst case scenario for the government is a Japanese-style deflationary depression, in which the value of the government’s liabilities rises in real terms, while the value of its most important asset is eroded by an ongoing output gap.

Deflation might not have seemed like an issue before Friday’s CPI report, but now the risk cannot be so easily dismissed. Most of the positive inflation in recent months appears to be the result of rapidly rising commodity prices, which are volatile and could easily reverse direction. Meanwhile, the US labor market is weak, and the financial system – what’s left of it – is fragile. If, by taking on certain (relatively small, in the grand scheme of things) financial risks, the government is able to materially reduce the risk of a financial collapse and thereby reduce the risk of a deflationary depression, there is probably a net decline in the government’s total risk.

To put it a little differently, as James Hamilton says, “you don’t get something for nothing,” but, it seems to me, if the something that you get is clearly worth more to you than the something that you gave up, you kind of do get something for nothing. Don’t you?

Now I like Eliot Spitzer

2008-03-15T11:06:00.001-04:00

Eliot Spitzer has always struck me as a pompous, self-righteous, arrogant, heavy-handed, politically motivated ass. I find the publicly disgraced hypocrite to be a much more sympathetic character. Pretty much the bad things about Spitzer were things I already knew. I didn’t know the specifics of his being a john and a philanderer, but neither did I imagine that he could possibly achieve for himself the high moral standard that he seemed to require of everyone else. The main difference now is that he’s been caught. And being caught tends to neutralize the things I didn’t like about him: his political career is over; his hand is weak; and he is no longer in a position to be pompous, self-righteous, and arrogant. He’s still an ass, I guess, but nobody’s perfect.

UPDATE: Now that I read about what Spitzer has done to reduce human trafficking, I like him even more. Not quite as cool as keeping abortion legal, perhaps, but surely it's worth at least a hand job.

This inflaiton report scares me.

2008-03-14T16:57:00.004-04:00

Quoting myself from the comments section of my last post:

...Japan had plenty of missed opportunities in the early to mid 90s to prevent the depression from getting out of hand. It was only when the inflation rate went to zero...that it really became intractable.

Speak of the devil, and he shall ~~arrive~~ appear. I'm pretty sure we'll get positive core inflation in March (and there's no question that we'll get positive headline inflation), but seeing zero even in one month (as in today's February CPI report), while commodity prices are rising at unprecedented rates, is pretty disturbing. Both the 12-month CPI inflation rate and the 3-month annualized rate are 2.3%, which is right in the middle of the normal range. This is disturbing because it seems to indicate that business don't even have enough pricing power to pass on part of the huge cost increases they are facing in energy and materials. What happens when commodity prices stop rising? I don't think I want to find out.

Rising Inflation Expectations: Bad News or Good News?

2008-03-09T19:29:00.006-04:00

Suppose that Greg Mankiw and others are correct in suggesting that inflation expectations have risen dramatically. Is this bad news or good news?

By way of full disclosure, I should note that it’s clearly good news for me, since I’m short nominal Treasury notes. If you follow the logic, that means it’s in my interest to convince other investors that conditions are more inflationary than I really think they are, so while the main point of my last post still stands, you should probably take the caveats (“There's little question that the expected inflation rate has risen...”) with a grain of salt. (Rising inflation expectations are clearly good news for me, but if this is what the good news looks like, I’d hate to see what happens to nominal yields when inflation expectations are falling!)

As to the “general interest,” however, the most obvious interpretation is that rising inflation expectations are bad news, because they mean that markets have lost confidence in the Fed’s willingness to keep inflation within its perceived target range. Or, as Greg puts it (quoting the Cleveland Fed’s Web server and adding a double entendre), “the system ‘has experienced an unexpected error.’” If the market loses confidence in the Fed’s inflation target, then, theoretically, the change in the expectations term in the Phillips curve causes it to shift upward, and we can anticipate both higher unemployment rates (in the short run) and higher inflation rates (in both the short run and the long run, unless confidence is eventually restored) than we would otherwise experience at any given level of aggregate demand.

Under that interpretation, the higher unemployment rates in the short run are clearly bad news. As for the higher inflation rates, I’m not so sure. A slightly different, but related, interpretation is that the market correctly perceives that the Fed has finally come to its senses and raised its inflation target from an unreasonably low level. Indeed, the current crisis, in which reasonable people are worried both about inflation becoming unhinged and about a potential deflationary collapse, is a good demonstration of why the target should be higher. It is kind of hard to believe that the Fed has come to its senses, though, since the rest of the world’s major central banks have been even further from their senses than the Fed.

Even if you think the Fed’s perceived* inflation target (between 1.75% and 2% on the personal consumption deflator, which is maybe about 2.25% to 2.5% on the CPI) is reasonable, you might think there are certain situations where the target should be raised. One of those situations might be a “safety trap” – where investors shun all but ultra-safe assets, even when the expected returns become much lower than those on risky assets. Arguably (though the argument becomes much weaker when you look at the stock market instead of the credit markets) the US is experiencing a safety trap now, and one solution is to take away the safety of the supposed safe asset by promising to inflate away the returns to be earned by government bondholders. Another situation where raising the target might be a good idea is when the uncertainty around the expected inflation rate increases, so that pursuing the original target would produce a significant risk of deflation. There might be a fairly strong case (as I suggest in the previous paragraph) that the US is in that situation right now. Obviously if you think that current circumstances call for an increase in the inflation target, then it is good news to learn that (in the judgment of the market) the target has actually increased.

But all these interpretations assume that the general shape of the distribution of inflation possibilities remains roughly the same. Moreover, casual talk of “expected inflation” suggests that we think the mean and the median of the distribution are roughly the same, since “expected inflation” could refer to either one. But perhaps what has happened is that the mean of the distribution has risen but the median has not. I would interpret the Fed’s target more as a median than as a mean. I would certainly hope that it isn’t the mean, and that the Fed would be more willing to tolerate inflation rates 3% above its target (high by recent standards but far from disastrous) than rates 3% below its target (deflation, which could be disastrous). Under this interpretation, the market still has confidence in the Fed’s target as a median, but the market is reassured that extremely low inflation rates will not be tolerated, so that the distribution has become more skewed to the right, and the mean has risen. In that case, the increase in mean (but not median) inflation expectations is good news.

[UPDATE: Paul Krugman, using what seems to be another species of the "in this situation, the inflation target should be raised" argument, makes the case that high inflation expectations are good news.]

*The Fed has actually announced a 3-year-ahead forecast, which can perhaps be reasonably interpreted as a target.

Inflation Expectations

2008-03-09T12:16:00.003-04:00

This chart is showing up in too many places. The latest, to which I link, is Greg Mankiw's blog.

The implication is that the expected CPI inflation rate over the next ten years has risen from its typical value of around 2.5% to around 3.4% recently. There's little question that the expected inflation rate has risen over the past couple of months, with commodity prices rallying like never before (literally), and that is certainly an issue that the Fed has to be concerned about, but do we really believe that the expected inflation rate has risen quite so dramatically?

I don't. If you look at the raw breakeven inflation rate from the 10-year tips-to-nominals spread, it has only risen by about 20 basis points in the past couple of months, and it still hasn't taken out the highs that it made in 2005 and 2006. We can reasonably surmise that this understates the increase in expected inflation, since we also know that liquidity has gone to a premium over the past 6 months and that TIPS are less liquid than nominal Treasury notes. We can't quite be sure, though, because inflation uncertainty has also increased, so the increased risk premium for inflation uncertainty (which applies to nominal Treasuries) may be offsetting the increased liquidity premium (which applies to TIPS).

The 3.4 percent figure comes from a very specific way of estimating the liquidity premium. IIRC the Cleveland Fed does a regression on the spread between on-the-run (recently auctioned and therefore highly liquid) and off-the-run (slightly less liquid) Treasury notes. Recently that spread has increased dramatically, so the methodology is adding a large liquidity premium onto the expected inflation rate. But how large, exactly, should it be? Given that liquidity conditions are outside the range of the data prior to August 2007, and given that I think there are omitted variables (specifically, a time trend over the period during which TIPS were becoming more available and gaining more market acceptance, as well as a reverse time trend at the very beginning, when TIPS were new and exciting and therefore didn't need to offer high yields) in the specification, and given that I'm not sure that the on-the-run-to-off-the-run spread is the best measure of the liquidity premium anyhow, and given that there are issues about the inflation risk premium, I'm not at all comfortable accepting the Cleveland Fed's estimate.

Tax That Guy Behind the Tree

2008-02-22T17:16:00.003-05:00

Megan McArdle is right (here and here), and Henry Farrell and Mark Kleiman are -- perhaps not exactly wrong, but as far as I can tell, they are either misunderstanding what she says or quibbling on minor points of semantics while apparently believing themselves to have a substantive point. The question is, "Do people want their own taxes raised?" My answer comes more from introspection than from logic or economics. Perhaps Henry Farrell and Mark Kleiman want their taxes raised, but I certainly don't want mine raised. However, I am willing to have my taxes raised in exchange for certain things that I do prefer -- in particular, I'm willing to have my taxes raised in exchange for an increase in everyone else's taxes.

I want to make it quite clear that I will oppose any law that tries to raise my taxes by $300 -- unless that law also contains provisions that I support and that are worth $300 to me. Would a provision requiring my compatriots to kick in a total of $6,000,000,000 to the National Science Foundation be sufficient to gain my support for the package? Hell, yes! I would support the package because the provision that I like (a $6,000,000,000 increase in taxes from everyone else, to finance the NSF) far outweighs the provision that I don't like (a $300 increase in my own taxes). That doesn't mean I like paying $300 more in taxes. When I refuse to make an autonomous contribution to support NSF-like research, I am indeed revealing my preference for not paying more taxes. (And by the way, if someone proposes to exempt, say, people who were, as of February 2008, blogging using a vowelless pseudonym, from a new tax, I will support the amendment, because I really would prefer not to pay more taxes.)

It seems to me that much of the popularity of the anti-tax movement that began with Reagan-Kemp-Roth (or did it begin with Kennedy-Johnson?) was based on an appeal to people's genuine preference for lowering their own taxes, combined with a sort of mental cover-up of the implications of taxing other people. Basically, get people to think about the $300 question and ignore the $6,000,000,000 question. On the pro-tax side, it is precisely the failure to acknowledge that people don't want to pay higher taxes that made it difficult to counter the appeal of the anti-taxers. The pro-taxers insistence on philosophical mumbo-jumbo about collective action and such covered up the fact that they had a very strong common-sense case that they were somehow unwilling to press.

There is a valid concern that revenue doesn't quite rise linearly with tax rates and that high taxes can produce certain economic inefficiencies, but to me the basic math has always looked very good for taxes (in a large country like the US): even if the money is spent very inefficiently and not on my own priorities, $6,000,000,000 is a hell of a lot. The government would really have to make an incredibly huge mess of its spending in order for that not to be worth $300 to a reasonable person. (But again, if you could get it for free, that would be even better.)

St. Augustine

2008-02-18T20:59:00.005-05:00

I guess I was a little early with the Augustine reference back in August 2006, and maybe I should have translated it into English, but it looks like it's finally catching on.

Not a Bubble

2008-02-15T12:27:00.005-05:00

Alex Tabarrok of Marginal Revolution has gotten a lot of (mostly dissenting) attention for his argument that there was no housing bubble (hat tip: hmm, I don't even remember, but I'll cite Paul Krugman, ~~Jane Galt~~ Megan McArdle, and Battlepanda, among the many who have pointed to the post). Alex Tabarrok reproduces Shiller's now-famous chart of housing prices over the past 100 years and comments:

The clear implication of the chart is that normal prices are around an index value of 110, the value that reigned for nearly fifty years (circa 1950-1997). So if the massive run-up in house prices since 1997 [culminating at an index value around 200] was a bubble and if the bubble has now been popped we should see a massive drop in prices.

But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average. Since the peak in the second quarter of 2006 prices have dropped by about 5% at the national level (third quarter 2007). Prices have fallen more in the hottest markets but the run-up was much larger in those markets as well.

Prices will probably drop some more but personally I don't expect to ever again see index values around 110. Do you?

As Battlepanda points out, "Do you?" is not a very convincing argument unless you already agree with him. But I think I can make it a little bit more convincing:

Prices will probably drop some more, but personally, given the likely effect that an additional 40% drop in home prices would have on the already weak economy, I don't expect that the Fed will allow index values to fall to anywhere near 110 in the foreseeable future. Do you?

Some people will respond with something like, "OK, I don't either, but that doesn't mean it wasn't a bubble; that just means there's a Bernanke put on home prices: there was a bubble, and the Fed is now going to ratify the results of the bubble." But that's not right. The Fed is not actively causing inflation in order to bail out homeowners and their creditors. The vast majority of professional forecasts call for the inflation rate to fall over the next few years. The Fed is just doing its job -- trying to keep inflation at a low but positive rate while maximizing employment subject to that constraint. The ultimate concern of the Fed is to avoid deflation, which becomes a serious risk if the US housing market has a total meltdown. It's very much as if the Fed were passively defending a commodity standard, with the core CPI basket as the commodity.

The ultimate source of the housing boom is the global surplus of savings over investment. That surplus is what pushed global interest rates down and thereby made buying a house more attractive than renting. And that surplus is still with us. If anything, it appears to be getting worse, as US households begin to reject the role of "borrower of last resort." And it is that now aggravated surplus that threatens us with weak aggregate demand and the risk of economic depression in the immediate future -- a risk to which the Fed and other central banks will respond appropriately. Until the world finds something else in which to invest besides American houses, the fundamentals for house prices are strong -- not strong enough, probably, to keep house prices from falling further, but strong enough to keep them well above historically typical levels.

Marginal Taxes on the Rich

2008-02-12T08:56:00.000-05:00

In response to the opening sentence of my last post, Greg Mankiw asks:

Have you ever turned down a money-making opportunity that you would have accepted if it paid twice as much?

I'll outsource the first part of the answer to "a student of economics," who comments on Greg's post via the comments section of my last post:

Greg asks the wrong question in an effort to get the answer he seeks.

The correct question should be, "would you turn down that opportunity if ALL your other money making opportunities also pay twice as much?"

It's not clear that I would do anything different if all my options improved by the same amount. There are only so many hours in day. In fact, perhaps I would actually work less and play more if I were twice as rich (assuming, of course, all gov't services magically continued without cost).

I do recall once having two job offers at comparable pay, and I'm sure that, if the one I rejected had paid twice as much, I would have taken that one instead. But it's pretty obvious that has nothing to do with taxation; it has to with what other opportunities are available. If both jobs had paid twice as much, I would have made the same choice that I did.

Part-time opportunities are a separate issue. I don't have a clear memory on this point, but it's quite possible that I've turned down consulting work that I would have accepted if it paid twice as much (though again, if all opportunities paid twice as much, I'm not sure how the income and substitution effects would sort out). In my case, though, the example (if there is one) would make my second point: that the incentive effects of higher marginal tax rates are not all bad. If I did turn down an assignment, it would be a job in support of one side or the other in a legal case or an interest arbitration. Given the near zero-sum nature of such proceedings, the negative externalities associated with my activities would have been quite high. In this case, the tax is Pigovian, and I'm confident that it's nowhere near high enough to equate the private rewards with the social value of such work. I've made a similar point before.

[UPDATE: Boy, my two sentences introducing a different topic are generating quite a large tangent. PGL at Angry Bear has this to say.]

UPDATE2: In a Update, Greg gets into the whole income and substitution effects business and argues that he is asking the right question because he is isolating the substitution effect, which is what matters for deadweight loss. But for most real-life examples, he's still wrong. It's fairly obvious in my example of having two job offers, but it's true in a lot of more subtle cases too, that one is not really making a substitution between labor and leisure; rather, one is substituting one labor opportunity for another. Usually, one doesn't have a firm offer for the alternative opportunity, but one has some reasonable idea of what opportunity may become available. If a job offer gets doubled, it becomes unrefusable simply because one will never get another offer so big.

It's true that, to the extent that one has marginal opportunities, as in my consulting example, there may be labor-leisure tradeoff, but even there to a large extent it may actually be an intertemporal tradeoff between different labor opportunities given a more-or-less fixed amount of total leisure over time. And I would reiterate my point that the taxes in these marginal cases are often Pigovian.

[UPDATE3: While we're on the topic, let me point back to this post in which I argue that progressive taxation (though not high overall taxation) can actually encourage entrepreneurial activity.]

Marginal Taxes on the Poor

2008-02-11T16:49:00.000-05:00

I've always been skeptical of the importance of the purported bad incentive effects of high marginal tax rates on high income earners. (I won't go into the details now, but I don't think the incentive effects are very strong -- at least at tax rates close to current tax rates -- and I don't think they're all bad.) For some time, though, I have been concerned about the effects of effective marginal taxes on low income earners. The problem is not the taxes they pay to the IRS (which they mostly don't, anyhow) but the effective taxes they pay to various subsidizers, price discriminators, and assistance providers in both the public and private sectors.

It has worried me that there might even be some point on the lower part of the income spectrum where the effective tax rate is greater than 100%. That is, you get more income; you no longer qualify for various assistance and subsidies; you slide up the "sliding scale" of various vendors and service providers who (officially or unofficially) give discounts for the financially challenged; you pay more in FICA and state and local taxes (even if you still don't pay Federal income taxes, which you might); and you end up worse off (even leaving aside any reduction in leisure) than when you had less income.

It turns out this was more than a theoretical possibility. Jeff Frankel (hat tip: Greg Mankiw) quotes Jeff Liebman with a story about a woman who "moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn’t make ends meet any more." In her case it wasn't until after the (apparently irrevocable) decision that she discovered what a bad deal it was to make more money, so maybe the incentive effect per se wasn't a problem, but even someone like me, dubious as I am about "justice" as a moral concept, has a sense that this woman has been cheated and that what happened is "wrong." And eventually we have to assume that the incentive effects will matter: presumably Abraham Lincoln was right that you can't fool all of the people all of the time. Moreover, the incentive effects will matter even when the effective tax rate is "only" 80% or 90%. And it can only get worse when we begin to attempt universal health care on a national level.

In theory the solution is to consolidate all forms of public (and ideally, private) assistance into a single, fairly large grant, which can then be taxed away via the income tax at a reasonably slow rate for people who don't need it. That obviously isn't going to happen, and I don't have any other solutions to offer, but Jeff Frankel notes in passing that Jeff Liebman is an economic advisor to Barrack Obama. Given that Senator Obama is now the (not quite odds-on, as of this morning) favorite for the next presidency, I'm heartened that at least one of his economic advisors is thinking about the problem.

[UPDATE: My next post deals specifically with the issue raised in the first two sentences about high income earners. I guess it's hopeless, though, for me to get people to break that thread here and post comments on that more relevant entry.]

Has expected inflation really risen?

2008-02-03T22:49:00.000-05:00

Several economics and finance bloggers, such as Greg Mankiw and Felix Salmon, have been pointing to an apparent increase in long-term inflation expectations in the TIPS market that Greg Ip wrote about Thursday in the Wall Street Journal’s economics blog. It would all be very worrisome to me, except that when I look at the actual data, they don’t seem consistent with a reasonable story about rising inflation expectations.

Greg Ip gives a clear description of the indicator being used and why it is used:

The Fed has long looked at the difference between yields on nominal Treasurys and inflation-protected Treasurys (TIPS) for a sense of what investors expect inflation to be. The difference is the so-called “breakeven” rate — the inflation rate that equates returns on the two. The Fed also tries to strip out near-term inflation disturbances related to fluctuating energy and food prices by looking at what the market expects inflation to be starting five years from now and running for the next five years (i.e. from 2013 to 2108). This is the “five-year, five-year forward” breakeven rate.

I’m not sure exactly how the Fed, or Barclays Capital (the source for Greg Ip’s numbers), does the calculation, but I’m going to use what I think is a reasonable approximation. (I emphaize that it is an approximation, most likely not the calculation that the Fed does, but it should give a reasonable idea of what the general picture looks like, and it has the advantage that I can do it in my head just by looking at four easily available yields.) Here are the four relevant pieces of data for my approximation, taken from the Fed’s constant maturity data for two points in time (the day before Ben Bernanke’s Jan. 10 speech, and the day before Greg Ip’s Jan. 31 blog post):


                                Jan 9   Jan 30
5-year TIPS yield               0.94%    0.84%
5-year nominal treasury yield   3.10%    2.96%
10-year TIPS yield              1.56%    1.45%
10-year nominal treasury yield  3.82%    3.78%

Using brute force subtraction, these data imply the following approximate current breakeven inflation (BEI) rates:


                                Jan 9   Jan 30
Current 5-year BEI              2.16%    2.12%
Current 10-year BEI             2.26%    2.33%

The approximate “five-year, five-year forward” breakeven inflation rate is two times the 10-year BEI minus the 5-year BEI, as follows:


                                Jan 9   Jan 30
5-year, 5-year forward BEI      2.36%    2.54%

This change is similar to what Barclays found, so I trust that my approximation isn’t too far off. But it’s important to think about the current BEI rates and what they mean. The first thing you should notice is that the current 5-year BEI rates are below the 5-year forward BEI rates. That should make you a little suspicious already. Think about those “near-term inflation disturbances related to fluctuating energy and food prices” that the Fed is trying to filter out. There has been a huge run-up in commodity prices over the past 6 months, and over the past 5 years. Presumably this should have more effect on the inflation rate over the next 5 years than it will on the inflation rate over the subsequent 5 years. If these BEI rates were unbiased indicators of expected inflation, you would probably expect the current BEI to be higher than the 5-year forward BEI. Not that anyone really thinks they are unbiased indicators, but this observation underscores the point that risk premiums and liquidity premiums are more important than inflation expectations when comparing the behavior of different 5-year and 10-year securities.

Take a look specifically at the change between Jan. 9 and Jan. 30. The current 5-year BEI rate actually went down by 4 basis points. That observation, it seems to me, is rather hard to reconcile with a story that says investors were reacting to a dovish shift in Fed policy. Is there any way that a dovish shift could reduce the inflation rate over the next 5 years? Of course, the (inflationary) dovish shift might have been outweighed by (disinflationary) weak economic news. But in that case should we really be worrying about inflation expectations? In particular Greg Mankiw might need to reconsider his conclusion:

A rise in expected inflation is not consistent with the conventional wisdom that the economy is on the verge of a serious slump driven by inadequate aggregate demand. It is, however, consistent with the hypothesis that policymakers are overreacting to some bad economic news with excessive monetary and fiscal stimulus.

These data suggest to me that the chance of a serious slump has risen and that the monetary and fiscal stimulus has not caught up with that rising probability.

It’s still possible that the market’s perception of the Fed’s preferences has shifted in a dovish direction, and that would be one way to explain the behavior of the 10-year BEI. But in that case the market must also think the Fed will be less able to implement those dovish preferences in the immediate future.

An alternative explanation, which doesn’t require such a subtle analysis of the Fed’s preferences and abilities, is that inflation expectations in the near future have fallen (as the weak economic news would suggest) but that the liquidity premium on TIPS has also fallen (as have other liquidity preference indicators, such as the TED spread). If the same liquidity premium applies to 5-year and 10-year TIPS, then a drop in that liquidity premium, without any change in expected inflation rate, would result in higher current BEI rates at both the 5-year and 10-year horizon. That shift by itself would increase the 5-year, 5-year forward BEI rate. If, in addition to the drop in the liquidity premium, the current 5-year expected inflation rate fell but the 5-year forward expected inflation rate remained the same, that would result in exactly the pattern that we observe.

Monster Really Scares Me

2008-01-31T12:59:00.000-05:00

Just as I finished leaving a comment ~~(not yet accepted as of this writing)~~ on Paul Krugman's blog arguing that UI claims for January remain on balance in the "good news" column and that the personal consumption report is not bad news given what we already knew about retail sales, I learned that the Monster Employment Index (which measures online help wanted advertising) fell by a whopping 9 points (from 169 to 160) in January, after falling an even more whopping (but less surprising given the usual seasonal pattern) 14 points in December and a not so whopping (but still significant because the index has never dropped 3 months in a row before) 5 points in November. That makes a total drop of 28 points, or about 15%, over 3 months. Before December 2007, the index had never fallen by more than 3% over any 3 month period (since it began in October 2003). And note that the 15% drop comes as newspaper help wanted advertising is scraping against an all time low (since 1951, when the Conference Board's index began, but note that in December, it rose slightly from the all-time low in November). Over the past week or two, I had been starting to think that the odds were shifting against recession. Now I'm not so sure. In any case I think we can rule out the possibility that 2008 will turn out unexpectedly to be a year of normal growth. And I'm not so worried about import prices now; I think they'll be offset by a slowing of domestic inflation.

[UPDATE3: OK, now I found the post on Paul Krugman's blog where he said that someone else edits the comments. (I missed it the first time, because it was in an update that I didn't read.) And I notice that one of my comments on an earlier post has suddenly appeared. I guess they decided I was a respectable commenter after all.]

[UPDATE2: I removed the previous update, because ~~Paul Krugman (or~~ whoever approves comments for his blog) did approve my comment. (See link at the top.) I had assumed it wasn't going to be approved, because there were later comments comments already approved, but I guess these things don't necessarily go in order.]

[UPDATE: [removed] ]

Not Such a Weak Report

2008-01-30T10:09:00.000-05:00

Reading between the lines of the 4th quarter advance GDP report, I estimate that nonresidential final sales rose at about a 3% annual rate, which is about where I see the potential growth rate (and faster than the potential growth rate that the Fed sees). It thus appears that, in the 4th quarter, fundamental weakness was still localized in the residential construction industry, which will eventually get as small as it's going to get and stop bringing down GDP. While this report doesn't allow one to rule out the possibility that a recession began during the quarter, and it certainly doesn't foreclose the possibility of a recession beginning in 2008, it does, in my opinion, line up on balance as evidence against the likelihood of one.

When does monetary policy become ineffective?

2008-01-29T21:44:00.000-05:00

Mark Thoma* leaves a succinct comment on my previous post:

Where we differ is the point at which monetary policy loses its effectiveness - I think that happens way before i-rates hit zero.

It’s an interesting point, because it is a position that many economists (including Keynes himself) seem to have held over the years, but one which, as far as I can tell, has never made much sense.**

I should be more specific: It may make sense if you measure monetary policy in certain ways, but not if you measure monetary policy in the way that is reasonable given how today’s central banks set policy. One might be (but in my opinion shouldn’t be) inclined to measure monetary policy in terms of the volume of open market operations, or some similar measure. In that case, it is quite true that a volume of operations that was effective when the interest rate was 5% is no longer likely to be effective when the interest rate is 1%. And certainly the people responsible for conducting those operations do need to be concerned with the volume. But for us, as economists and such, who can and should view monetary policy with some degree of abstraction, it makes little sense to concern ourselves with the volume of such operations. The transaction costs associated with open market operations are tiny (and not proportional to volume anyhow); the market for Treasury bills to be purchased is vast and quite liquid; the absolute size of an open market operation is of little importance, except inasmuch as it affects other variables, such as interest rates. Moreover, the same argument applies to other “quantitative” measures of monetary policy, such as changes in bank reserves and changes in monetary aggregates.

Since today’s central banks (and the Fed in particular) generally define their policy stance in terms of an interest rate, the reasonable way to measure that stance is in terms of an interest rate. Now one might argue (but again, I don’t think one should) that a proportional change in the interest rate that was effective when the interest rate was high will no longer be effective when the interest rate is low. For example, if the interest rate is 8% and you lop off one fourth of it, making the interest rate 6%, that could be quite an effective policy move; but if the interest rate is 1% and you lop off one fourth of that, making the interest rate 0.75%, that is not likely to be very effective at all by comparison. But central banks don’t measure interest rates proportionally, they measure them in…usually 25 basis point increments. And a 75 basis point cut by the Fed, for example, is considered a big move whether the interest rate starts at 8% or at 3%. The sensible question, it seems to me, is whether the effect of a given cut – defined in basis points – will be diminished when interest rates are already low.

If anything, I would argue, the exact opposite should be true. Monetary policy works largely by affecting the discounted value of expected returns on capital assets. When the Fed cuts interest rates, all other things being equal, stocks are worth more, houses are worth more, factories are worth more, machines are worth more, contemplated investment projects are worth more, and so on. The more the value of an asset rises relative to the cost of producing it, the more it becomes profitable to employ people in producing that asset. And theory says this effect should get stronger the lower are interest rates to begin with.

To see the point, consider a world where the risk premium is not an issue and where the Fed sets long-term interest rates. And just to make it clear, consider the extreme case where “long-term” means perpetual. In that case, the value of an asset that produces a fixed stream of returns equals the value of the periodic return divided by the interest rate. Thus if the Fed were to reduce the interest rate from 5% to 4%, it would increase the value of such an asset by 20%. But if the Fed were to reduce the interest rate from 1% to 0%, it would increase the value of the asset by…well, you do the math. In the enterprise of producing an infinitely valuable asset, it is of course profitable to employ as many people as you possibly can, at whatever wage they might require. In the real world, where the Fed controls only short-term rates, and where there is a risk premium associated with most assets, the effect is not so dramatic, but the difference in the effectiveness of policy when interest rates are low vs. high should certainly be in the same direction.

If, therefore, we may define “monetary policy” as the manipulation of an interest rate by a central bank, then we should expect that monetary policy gains more effectiveness the closer the interest rate comes to zero. And indeed, technically, there is no point at which monetary policy, thus defined, “loses its effectiveness.” There is, of course, a point at which additional stimulative monetary policy becomes impossible to practice, namely, the precise point when the interest rate reaches zero.***

* As far as I know, this is the real Mark Thoma – by which I mean the one that writes Economist’s View – not someone else of the same name. As an aside, though, it occurs to me that there is no shared authentication between Blogger and Typepad, so one doesn’t really know such things for sure. If I wanted to, I could probably post comments on other people’s blogs while pretending to be Brad DeLong or Barry Ritholtz. Or one of them could pretend to be me – though it's hard to think of any reason why they might want to.

** Please do not fear, Gentle Reader, that I have entertained for even a brief moment the abominable heresy that St. Maynard may have held a view that was in any way unreasonable. (Indeed, at the very thought, I must ask you to excuse me while I make the sign of the Keynesian cross over my chest.) Rather, I merely posit that there are certain inherent difficulties in communication between the Truly Awakened and ordinary sentient beings such as we. Interpreting the words of our lord**** in accordance with the mere shadows that form our limited experience, it is we who may have fallen into error. I’m personally intrigued by an alternative exegesis preached to me once by radical political economist Stephen Marglin, who suggests that Keynes was referring not to a lack of effectiveness per se but to the political difficulties in implementing a very low interest rate policy in an economy where the rentier class is loath to give up the income it receives in the form of interest.

***Strictly speaking, this is not quite true. Interest rates on some Treasury bills went below zero in 1938. Apparently, there are some people out there who like their Treasury bills so much that they won’t give them up even if you offer a premium to redemption value.

****I trust that the lower case L keeps me safe from the charge of blasphemy. Surely the lord I have in mind was indeed ours. To whom, after all, could Keynes belong***** if not to the Keynesians.

*****Actually, I have nothing to say down here, but I got so fascinated with the idea of nested footnotes that I decided to push the concept one level further.

What is the purpose of a fiscal stimulus?

2008-01-28T08:20:00.000-05:00

In the course of thinking about my last post, I have come to a striking realization: the (primary) purpose of a fiscal stimulus is not, as commonly believed, to stimulate aggregate demand and thereby increase economic activity; the purpose is to prevent interest rates from going down.

If the purpose of a fiscal stimulus were to stimulate aggregate demand and thereby increase economic activity, then a fiscal stimulus would almost never be a good idea. Typically, when a fiscal stimulus is proposed, one will hear arguments against it from various economists, typically of the more conservative-leaning variety (as, for example, Andrew Samwick here). These arguments rest on the premise that the conventional reason for a fiscal stimulus is the true reason. They argue (in my opinion) convincingly that that reason is not a good one, and they conclude that a fiscal stimulus is a bad idea. Essentially, anything that fiscal policy can do, monetary policy can do better. And monetary policy will do it, because that’s the job of central bankers. And if you disagree with the central bank about whether we need a stimulus, it will do you no good to try to use fiscal policy unilaterally, because the central bank will act to offset the effect with higher interest rates.

There is one exception – one case where monetary policy (maybe) just doesn’t work: that is the case where the interest rate is zero. In that case, there is no opportunity for the central bank to stimulate the economy by reducing interest rates. And if the central bank tries to stimulate the economy just by increasing bank reserves, this may be ineffective, because banks, having obtained the funds at zero cost, will feel little pressure to make loans; they may simply hold all the extra reserves as free insurance against the prospect of unexpected cash needs. And moreover, their creditworthy customers may not be willing to borrow, even at extremely low interest rates, if they can’t think of anything good to do with the money. This may or may not have happened in Japan; it’s still controversial whether the Bank of Japan’s policy of “quantitative easing” had a major impact. Anyhow, it’s something to worry about.

But in the US, for example, the interest rate has not been zero since 1938. So this one exception does not apply. If you’re worried (like Paul Krugman) that the exception might apply at some point in the not too distant future, then your argument about today is not that the exception does apply, but that we need to take action to avoid the situation in which the exception would apply. In other words, you don’t want interest rates to go too far down. You want a fiscal stimulus to prevent interest rates from going down.

Alternatively, let’s say that you were calling for a fiscal stimulus (or perhaps a larger or better directed one than what we actually got) in 2001 and 2002 and that you had the foresight to see that a monetary stimulus would affect the economy by producing an excessive and ultimately destructive housing boom. If your foresight were that good, you would probably have seen also that the monetary stimulus would succeed in getting the economy going and getting the unemployment rate down. So you couldn’t advocate a fiscal stimulus for that purpose, which would already be served. Rather, you would advocate a fiscal stimulus to avoid an excessive housing boom – by preventing interest rates from going down.

Today it would be hard to argue that a monetary stimulus could spark another excessive housing boom. (It might, I think, spark some kind of a boom, but the boom will be more orderly and rational, given the “once bitten” status of the housing market, as well as the elimination of many of the prospects for creative financing.) But a monetary stimulus could have another bad effect – rising import prices due to sudden drop in the dollar. The way to avoid that effect is to keep US interest rates high enough to attract capital from abroad, which will prop up the dollar. And the way to do that is with fiscal policy – a policy to produce a demand for that capital, so that someone in the US will be willing to pay those interest rates. Again, the purpose of a fiscal stimulus is to prevent interest rates from going down.

[Update: pgl's response at Angry Bear makes me realize that my reference to "another bad effect – rising import prices" was misleading. Rising import prices are a good thing, in my opinion, in that they would help reduce the international imbalance (the large net inflow of goods to the US from Asia), but on balance, only a good thing if the prices rise slowly enough to avoid a dramatic deterioration of the output-inflation tradeoff (i.e. stagflation, or something like it). The argument for using a fiscal stimulus, and therefore having relatively higher interest rates, today is that higher rates would let the dollar fall gradually, thereby avoiding the shock from a sudden deterioration in the terms of trade. It would also avoid a sudden contractionary shock to the rest of the world's economy.]